Why can't the Fed just buy yuan?

The title really says it all. And it's not a rhetorical question; I don't know the answer. But if the US is really concerned (H/T Mark Thoma) about the US dollar being too high against China's yuan, and it believes China is "artificially" preventing the yuan from appreciating against the dollar by foreign exchange market intervention, why can't the Fed just intervene in the opposite direction, by buying yuan?

Currency pegs are usually unilateral; at one time the Bank of Canada used to peg the Loonie against the US dollar. Sometimes currency pegs are bilateral; before the introduction of the Euro, France and Germany jointly intervened to keep the franc/mark exchange rate at an agreed on value. But it would be interesting to see what happened if China were trying to depreciate the yuan against the dollar, and the US were trying to depreciate the dollar against the yuan. Who would win?

Regardless of who would win, the attempt by each side to depreciate its currency against the other would increase the world money supply. Not such a bad war to have, at the moment. What's the opposite of "collateral damage"?

Update: In response to anon's comment, let me be very concrete. Suppose the Fed opens a window, somewhere on US soil, and posts a notice saying "we will buy unlimited quantities of yuan currency, bonds (or even good quality commercial paper?) at a price of X, no questions asked". Where X is above the current exchange rate set in China. What would happen? (One thing that won't happen is that China would threaten to nullify that currency or bonds, because a moment's reflection would convince China that that's a war they would definitely lose!)

anon: but exactly *how* can China stop the US buying yuan? What does it really mean to say the yuan is "non-convertible" outside China? Sure China has a "rigid peg/manipulation" of its exchange rate. But if that peg is created by China's buying dollars, what is to stop the Fed from establishing its own "rigid peg/manipulation" of the exchange rate, at a different exchange rate, by buying yuan?

Mike: it's the sort of question I can imagine a bright first year student asking. And I'm embarrassed too that I hadn't thought of it until this morning, and wouldn't know how to answer a student who asked it.

Of course, most of the dollars that flow into China are on current account, resulting in PBOC buying dollars and issuing Yuan to Chinese residents - not foreigners.

That leaves the capital account.

The Fed wouldn't be able to buy Yuan without PBOC approval.

Basically, the US government would require Chinese approval to "purchase" any Yuan denominated Chinese financial asset (including Yuan bank deposits), which is what they'd have to do to build Yuan reserves.

E.g. the US government can't go to a US investment dealer and buy Yuan. Can't be done.

The only exception are "non-deliverable" forward markets, which as you can tell by the name, are hedging and betting oriented, but don't have access to the actual FX - i.e. they are US dollar cash settlement for FX differentials, not Yuan settlement for contracted exchange. And they are relatively illiquid markets. If the US wants to get into the casino business to try and drive the Yuan higher, I suppose it could, but the liquidity wouldn’t be there. And there would be no actual reserves. Apart from being shady, it would backfire.

The Fed can't prevent the Chinese from buying dollars, unless as a impeding measure it prevents US residents from paying for Chinese imports in dollars and it prevents US residents from moving dollars into Chinese approved investment in China. But it certainly can't prevent the Chinese from buying any dollars that already exist (e.g. in bank deposit form) free floating in the world outside the US today.

"Mike: it's the sort of question I can imagine a bright first year student asking. And I'm embarrassed too that I hadn't thought of it until this morning, and wouldn't know how to answer a student who asked it."

I'm just really glad none of my students thought of asking! I teach a 4th year undergrad course on International Trade at Ivey, and this entire week was devoted to exchange rates. It could have easily come up.

Remember when someone was asking what the returns to blogging were? This is an excellent example of the returns to blogging: instant high-quality answers to questions about things we'd like to know more about but don't.

When I say capital controls, some dollars get in, some Yuan get out. But the important word is control - tight and sufficiently tight to control the FX level at home - where (because of the corresponding foreign supply tightness) the vast bulk of FX transactions must be done by default.

China will internationalize the Yuan eventually at their chosen pace (chosen pace like with everything else) - it's the key to it's global ascendance, and its the key to eventually resolving global imbalances, which will happen over the very long term, and will happen only because China will eventually internationalize the Yuan. They're in the driver's seat, even if it does cost them in terms of some dollar depreciation.

Stephen: yes, these are exactly the returns to blogging, and thanks to anon. (Hey anon, like to give yourself another nom de plume, so we can distinguish you from other anons?)

But it's still not fully clear to me.

Let me re-pose the question a different way: If the Fed sets a dollar/yuan exchange rate of X on US soil (which it can do, by opening a window), and the Bank of China sets a dollar/yuan exchange rate of Y on Chinese soil (which it can do also, by opening a window), and X \= Y, then what is *the* exchange rate? Is it X or Y? Why one matters for exports and imports between China and the US? And why? (Which direction would the suitcases full of cash need to travel?)

Isn't the problem somewhat political? In order to buy yuan, they would create more US dollars, which would also depreciate the dollar against other currencies at a time when the electorate and political establishment fret constantly about the low dollar.

If the gap between the Chinese and US exchange rates were sufficient, someone would figure out a way to thwart the capital controls. Money is a powerful motivator.

The Chinese CB will buy yuan and give you US dollars at some rate they fix.

The Fed would also buy yuan and give you more US dollars per yuan the the BoCh to drive the yuan up relative to the US dollar. And since everyone with yuan would clearly prefer to get more US dollars per yuan, they'd go to the Fed and not the Chinese CB.

But the problem is, due to capital controls, nobody can get to the Fed with a suitcase (or bank account) full of yuan because it is not possible to transfer yuan out of China through 'normal' channels (i.e. electronic transfer), and the Chinese border guards with the automatic rifles and surgically removed senses of humour take a dim view of people leaving China with suitcases of currency.

I think my understanding is about like Patrick's. If US exports earn yuan, it is illegal to stuff those yuan in a suitcase and bring them to the US, which you would need to do to change them for dollars at the Fed's window. So it all depends on whether enough smugglers can be found who will smuggle yuan out of China to earn the differential? Might make a nice sideline for the drug and people smugglers, especially since the US border controls would welcome them.

Is it also illegal to stuff yuan bonds in a suitcase and bring them out of China?

Anyone old enough to remember the big "Eurodollar" market (dollar denominated bank accounts held in European banks to get around US interest rate ceilings)? What about "Ameroyuan"? Could that work?

The Fed can open a window, but what Yuan will it attract other than currency effectively smuggled out of China? Yuan currency floating around outside of China would be very limited. And the Fed won’t attract money sourced from Yuan bank deposits, because that money is subject to capital controls as a flow out of China.

The exchange rate that matters is the one determined by PBOC. That’s where Chinese exporters sell dollars and where importers source dollars. PBOC is effectively a near monopoly exchanger of Yuan for dollars.

In Nick's scenario, the effective exchange rate would be the Chinese one. If the Fed is offering a higher price for yuan (i.e. a lower dollar valuation) than the PCB, then the small amount of available paper currency would quickly be sold to the Fed and then the discrepancy would go away, as there would be nothing left for the Fed to buy. It's like the short-side rule in disequilibrium - the exchange rate is determined by whoever can keep going the longest, which in this case is the PCB due to those capital controls.

If on the other hand there were no controls, people would simply keep arbitraging as long as the central banks are willing to keep printing money. If they can print at the same rate, the exchange rate won't change; perhaps if one of them has better market access or more effective auction mechanisms of some kind, that one will do a bit better.

As Steve Wright said, "For my birthday I got a humidifier and a de-humidifier... I put them in the same room and let them fight it out."

Assuming they humidify and de-humidify at the same speed, then eventually, as Nick says, both money supplies would increase until some target is reached. By this time, whatever the dollar-yuan exchange rate, both currencies would be hugely devalued against the Euro. The Europeans (and the Canadians, and the British) would be stuck with the problem - until of course they join in the inflationary spiral themselves.

I suppose if all the central banks want to keep doing this, then there's nothing to stop them. It's easy to unilaterally generate inflation, after all - at least we used to think so. But nobody can "win" permanently.

Devaluation is supposed to always be a short-run phenomenon - presumably money illusion only lasts so long. If your dollars and yuan can only buy 1/10 of the oil or German machinery they used to, you will sooner or later ask for a wage rise which cancels out the competitive advantage of the weaker currency. In the real world these adjustments do seem to take a while. So in the short term, whichever bank moves faster might have an advantage. But I would expect the disruptive effect on international trade to be quite powerful, and both economies might lose out more than either would gain.

But the point is that the Chinese have a fixed rate currency, and maintain capital controls on it in order to maintain their ability to fix it. They are simply not ready to float or open up their capital markets yet. Their control includes implicit control over just how much the Fed can do to fight it - which is why the US can only jawbone about China changing its policy. There is no Fed FX intervention policy possible for a currency that can't be intervened due to the constraints imposed by the issuer of the currency.

interesting post. Dean Baker made the exact same point to me when discussing this a couple years ago: "Well guess what, we can just open a window and offer dollars at a 1-to-4 exchange rate"

Technically there is nothing to stop the US government from doing so, but ultimately I think that anon is right. With the currency controls still in place, I imagine that very little yuan would actually make it to that window.

from Krugman's article:
"Instead, Chinese authorities enforced that target by buying or selling their currency in the foreign exchange market — a policy made possible by restrictions on the ability of private investors to move their money either into or out of the country."

I think Krugman is a little bit off here. Private investors can move their money in and out of China, but only by exchanging it for yuan on the way in, and exchanging out of yuan on the way out, via SAFE. The main mechanism through which the Yuan is kept down is not through Forex interventions, the main mechanism is the currency control system administered by SAFE. Since they handle almost all of the exchange, they more or less ARE the market, their rate is THE rate. The rate in the (tiny and restricted) forex market for yuan closely follows the onshore rate, and I doubt that much intervention is even needed to keep it that way.

China really is in the drivers seat, and for the time being, there seems to be little hope of a revaluation. The only alternative is for the US to start slapping tariffs on currency manipulators, but that isn't very likely.

To add to the dire outlook, Hu Jintao is on the way out in 2013, and is going to be replaced by Xi Jinping (unless the succession battle gets REALLY ugly), the protege of Jiang and leader of the Gang of Princelings (rent-seeking, corrupt children of the old revolutionaries, who now control all of the state industries and embezzle massive amounts of money through them - over 90% of China's 100 billionaires are princelings). Unlike the Hu administration which made some attempt to revalue and rebalance the economy, I doubt that Xi will have any inclination to upset the status quo, as the peg is what ensures the centrality of the SOEs in their economy and hence his faction's power.

"The main mechanism through which the Yuan is kept down is not through Forex interventions, the main mechanism is the currency control system administered by SAFE."

Currency controls are a partial rationing mechanism for supply/demand - partial because they have to deal with net current account flows as well as gross capital account flows beyond that. But FX intervention is absolutely required to set the price.

"Since they handle almost all of the exchange, they more or less ARE the market, their rate is THE rate."

If the Fed buys large amounts of Yuan, then it could hardly help but overpay for the yuan it buys. Thus the Fed would lose wealth, there would be less Fed assets backing each dollar, and the dollar would fall against the yuan. The policy would "succeed" in driving down the dollar, but only because the US was throwing its wealth away. An American corporation could do the same thing by using its shares of stock to overpay for stock in a Chinese company. The American company's stock would certainly fall as a result, but there is nothing about that outcome that is desirable for America.

Suppose the Fed opens a window, somewhere on US soil, and posts a notice saying "we will buy unlimited quantities of yuan currency, bonds (or even good quality commercial paper?) at a price of X, no questions asked". Where X is above the current exchange rate set in China. What would happen?

What does the Fed do with the stuff? Ship it to China? The Chinese would presumably say, okay, we'll buy it back off you for dollars. They certainly would't credit the Fed's account with yuan if their law says foreigners aren't allowed to hold them.

Kevin: "What does the Fed do with the stuff?" The same as what China does with the US dollars it buys, I expect. Puts it in the vaults? But if China were to refuse to accept the validity of US-owned yuan paper, the US could easily retaliate and refuse to accept the validity of China-owned dollar paper. As I said above, that's a war that China would definitely not want to start.

Mike: But what does "overpay" mean in this context? You are assuming that the "fundamental" value of the yuan, relative to the fundamental value of the dollar, is what China says it is. Why isn't it what the US says it is?

anon (same "anon" for every comment here?): interesting pdf. It doesn't explicitly say that you can't stuff yuan in a suitcase and export it. But probably that just goes without saying.

I'm coming back to Neil's comment. "Money" (in this case an arbitrage opportunity) is a powerful motivator. If the Fed announced a commitment to keep on buying yuan at X for several years, and thus created a steady market demand at an assured price, who knows what ways people would find to get around currency controls. Especially given corruption in China.

hmm maybe I'm just not understanding the role of the forex market in all of this.
My understanding is that it was only opened in 2005, is relatively thinly traded, and only open to certain governments and institutions. Does it really require a great deal of intervention to maintain the band?

there's probably something I'm missing here. anon, could you perhaps explain the size and role of the forex market for RMB, or point me to a good source? As with most things China related, I find it hard to dig up much info on the web.

But the problem is, due to capital controls, nobody can get to the Fed with a suitcase (or bank account) full of yuan because it is not possible to transfer yuan out of China through 'normal' channels (i.e. electronic transfer), and the Chinese border guards with the automatic rifles and surgically removed senses of humour take a dim view of people leaving China with suitcases of currency.

Yes. No one can hold Yuan currency outside of the country. So the Fed cannot open an exchange in NY and accept suitcases of bills. The real question is whether the Fed can open an office in China and perform the same transaction. I'm not familiar with the laws.

This is not so different from US law--suitcases of currency surely isn't practical anyways. Foreign banks cannot hold dollars directly (yeah they can hold a bit of currency on-site and there is Fed office in NY dedicated to shipping currency overseas--mostly $100 bills, which is why the $100 bill is regarded as a proxy for foreign usage of US dollars).

No, they are required to use US banks to hold their dollars. Foreign sovereigns may not even hold the certificates of their US government debt. Those are also kept by the Fed.

The real difference is that foreigners (and foreign banks) can hold accounts at US Banks. The same is not allowed in China. THIS is the reason that there is an 'international' market in dollars.

BTW, your plan would not appreciate the yuan specifically, although it would depreciate the dollar against all other currencies. This is because the PBC sterilizes their support of the dollar by issuing a second currency (PBC bonds) that does not function as the medium-of-exchange but is used to subsequently withdraw the yuan used to support the dollar.

"I'm coming back to Neil's comment. "Money" (in this case an arbitrage opportunity) is a powerful motivator. If the Fed announced a commitment to keep on buying yuan at X for several years, and thus created a steady market demand at an assured price, who knows what ways people would find to get around currency controls. Especially given corruption in China."

My thoughts as well - I don't think the existence of currency controls are enough to prevent the U.S. from being able to manipulate the exchange rate.

"I'm coming back to Neil's comment. "Money" (in this case an arbitrage opportunity) is a powerful motivator. If the Fed announced a commitment to keep on buying yuan at X for several years, and thus created a steady market demand at an assured price, who knows what ways people would find to get around currency controls. Especially given corruption in China."

The thing is, that if you are looking to arbitrage the undervaluation of the currency, and the lack of PPP between the US & Chinese markets, there is an easier way to do it. It's perfectly legal and officially encouraged. All you have to do is order a boatload of Chinese sneakers/t-shirts/etc. and sell them on the US market. Taking undervalued currency out of the country = illegal, taking undervalued goods (non-input, finished consumer goods only) out of the country = legal. Why take the risk?

"I'm coming back to Neil's comment. "Money" (in this case an arbitrage opportunity) is a powerful motivator. If the Fed announced a commitment to keep on buying yuan at X for several years, and thus created a steady market demand at an assured price, who knows what ways people would find to get around currency controls. Especially given corruption in China."

The thing is, if you are looking to arbitrage the undervaluation of the currency, and the lack of PPP between the US & Chinese markets, there is an easier way to do it. It's perfectly legal and officially encouraged. All you have to do is order a boatload of Chinese sneakers/t-shirts/etc. and sell them on the US market. Taking undervalued currency out of the country = illegal, taking undervalued goods (non-input goods only) out of the country = legal. Why take the risk?

"BTW, your plan would not appreciate the yuan specifically, although it would depreciate the dollar against all other currencies. This is because the PBC sterilizes their support of the dollar by issuing a second currency (PBC bonds) that does not function as the medium-of-exchange but is used to subsequently withdraw the yuan used to support the dollar."

So China uses sterilised intervention to reduce the quantity of US dollars in circulation without increasing the quantity of yuan in circulation. And I was imagining that the US would use unsterilised intervention to increase dollars in circulation and reduce yuan in circulation.

Why would my plan not cause the yuan to rise against other currencies (exchange controls aside)? There would be fewer yuan in circulation.

"In response to anon's comment, let me be very concrete. Suppose the Fed opens a window, somewhere on US soil, and posts a notice saying "we will buy unlimited quantities of yuan currency, bonds (or even good quality commercial paper?) at a price of X, no questions asked". Where X is above the current exchange rate set in China. What would happen?"

What would happen? Are you serious?

China (who could print as much Yuan as they want) would simply walk up to that window with the equivilent of $400 trillion US dollars in Yuan and simply 'buy' 100% of America instead of only 25%.

Could not the Fed ship containers full of USD to China, and either exchange them for yuan to horde (or lend to borrowers in China), or even just to burn? Seems to me that China would have a hard time combating this. The Fed could even just overpay for goods.

Unless I'm mistaken, there isn't too much requiring the Fed's reserves to be domiciled in the US, other than threat of nationalisation. And as noted, China would lose that battle.

"Overpaying for yuan" means paying more than the backing of each yuan is worth. If the Chinese central bank holds various assets worth 1 oz. of silver as backing for each yuan issued, and if the Fed buys yuan for 1.01 oz each, then the Fed is overpaying. It's the same for any financial security. If Honda stock is worth $60, and Ford buys shares for $61, Ford loses wealth and Ford stock will drop.

Suppose the U.S. offers a dollar for 4 yuan (a roughly 40 percent depreciation of the dollar) China prints 1 trillion yuan and exchanges it for $250 billion (also printed by the Fed).

The U.S. Fed would have to hold the trillion yuan otherwise the yuan would be devalued. China also has to hold the $250 billion (i.e. can not exchange or buy anything with it) otherwise the U.S. dollar would depreciate.

Mike Sproul: OK, I see you're coming from the real bills/fiscal theory of the price level approach, in which money has a fundamental value. Sorry, but I don't buy that approach. the RHS of your equation is not exogenous.

Jan: as Leigh said: "As Steve Wright said, "For my birthday I got a humidifier and a de-humidifier... I put them in the same room and let them fight it out."". China could offset US depreciation attempts, and the US could offset China's appreciation attempts (ignoring currency controls). Who would win?

My approach to a theory of the price level would best be called the backing theory. The real bills doctrine has been so mis-stated (by its critics) that it is probably best to ditch the term. The fiscal theory is unrelated to my views. The backing theory only says that if a bank issues 100 currency units (dollars) in exchange for 100 ounces of silver, then each dollar will be worth 1 oz. I don't know what equation you were thinking of, but my equation would be ASSETS=LIABILITIES or 100 oz.=100E, where E=the exchange value of the dollar, or E=1 oz./$. If the bank then issued another 200 dollars in exchange for a bond worth $200, the equation would become 100+200E=300E, which again yields E=1 oz./$. Note that the value of the dollar is unchanged, in spite of the fact that the bank just tripled the money supply. The RHS of that equation is endogenous, in the sense that the bank controlled the quantity of money issued, but that says nothing about its validity.

Returning to the case of the Fed overpaying for yuan, a good comparison would be to suppose that this bank prints 100 new dollars, and spends them on 99 oz. of silver, thus overpaying for silver. The equation would then be 199+200E=400E, or E=.995 oz., for an inflation of .5%.

"China could offset US depreciation attempts, and the US could offset China's appreciation attempts (ignoring currency controls). Who would win?"

It may be helpful to think about who would come to the new FED window. That is, who want to sell their yuan for higher price in dollars? The answer is, people who sell US goods in China (=importers in China/exporters in US). They would choose new FED rate rather than current rate so that they can get more dollars for the same amount of yuan they earned.
However, in the foreseeable future, the quantity of US export to China would remain overwhelmed by that of Chinese export to US. So, considering the current torrent of capital flow, this counterfactual FED effort to create official black-market of yuan doesn't look like a big push-back.

Too much Fed: for once, we agree ;). I think the world money supply would expand, and all/both currencies would depreciate against real goods, which is what we want right now, to offset deflationary forces.

Mike Sproul: Agreed. "real bills" has a historical meaning, very different from it's fuzzier modern meaning. And "fiscal theory is different, though also a theory in which money+bonds has a fundamental value. "Backing theory" is a better name.

himaginary: I think you are right. Absent currency controls, the relevant exchange rate for US exporters would be the "made in US" exchange rate; and the relevant exchange rate for Chinese exporters would be the "made in China" exchange rate.

Brad Setser would not have had much patience for this discussion on his blog. He dealt first and head on with realities on the ground; not so much with make believe worlds that are at odds with real world conditions.

Let's look at the case of a money-issuing bank that turns over its profits to the government. It's easiest if we imagine that a private money-issuing bank in the UK has issued 100 paper pounds, against which it holds US government bonds worth $200. Setting assets=liabilities yields 200=100E, or E=$2/pound. If it is costless to issue pounds, and if the bank earns 5% on US bonds, then at the end of year 1, the bank will get $10 in interest, which it pays to the government, leaving it with $200 in bonds backing 100 pounds, so E is still $2/pound. In any future period, the bank will always have $200 of bonds backing 100 pounds, so the bank will always be capable of buying back all of its pounds for $2 each. In fact, if the pound ever fell to $1.99, the bank could make a profit of $1 by spending $199 of its bonds to buy back all 100 of its pounds, leaving it with $1 in bonds as pure profit. Thus the value of the pound stays at $2/pound forever, even though the bank turns all its profits over to the government.

Now suppose that printing and handling costs $6/year to keep those 100 pounds in circulation. At the end of year 1, the bank will get $10 in interest on the bonds, of which $6 goes to pay costs, leaving $4 profit, which is paid to the government. Once again the bank still has $200 of bonds backing 100 pounds, and the pound stays at $2 forever.

The original anon is correct. The key is to ask what a yuan is. Nearly every form of yuan needs at least the acquiescence of the Chinese authorities to have any value. If the Fed bought banknotes, suitcases (nay, containers) of banknotes would have to be smuggled out of China to make any difference to the exchange rate, the Fed would earn no interest on their holding, and the Chinese could simply mess up the scheme by changing their banknotes. If the Fed bought yen in a bank deposit, any transaction would normally settle through the Chinese banking system. The owner of bonds would typically be registered and principal and interest would be paid to the registered owner, and given the scale of yuan purchases necessary it would not be possible to hide behind a nominee. The only exception is offshore yuan, which ultimately requires someone other than the Chinese central bank to take the short side, which few are prepared to do.

A related question (which I used to raise on Brad Setser's blog from time to time, and wrote about on my blog) might be why the US does not use the same control to discourage China specifically from intervention (eg refuse to service treasury debt owned by China above some limit). I suspect that one reason is that the American authorities know that they would face a very painful adjustment if the Chinese stopped buying US assets without buying a lot more US exports.

Thanks, rebeleconomist, for bringing the discussion back to some of the facts.

Some additional facts/analysis:

“To an extent, a global role for the yuan appears inevitable. How widely a currency is used around the world is usually a function of how important its home country is to the global economy. During the 19th century, when the British Empire reigned supreme, the pound was the top international currency. Since World War II, that role has been played by the dollar, with the U.S. having by far the world's biggest economy. Now that China is rapidly charging up the list — it currently ranks third and could overtake Japan as No. 2 as soon as next year — there is good reason to believe the yuan could dash into the big league of global currencies.

Right now, however, the yuan is far from that league. In fact, it is practically nowhere to be found in world currency markets. The reason is Chinese policy. Government restrictions prevent the yuan from trading freely around the world or being fully convertible to other currencies in all financial transactions. The yuan's value is pegged to a basket of currencies likely dominated by the U.S. dollar and is permitted to change each day only within a narrow band. Under such limitations, China's dreams for the yuan cannot progress very far...

Some analysts say China is still far from ready to undertake the dramatic reforms necessary to allow the yuan to be a true international player. Making the yuan a freely traded currency would mean losing control over its value and flows of capital in and out of the country. This is a step Beijing's economic policymakers remain fearful of taking, since they still feel the need to protect China's developing domestic financial sector from shifts in the global economy. China sees its controlled currency as a "dam surrounding a reservoir, and the government doesn't know what would happen if it blew up the dam," says David Li, an economist at Tsinghua University in Beijing. "Would water flood out because the level inside the dam is higher than outside or would the opposite happen? That's what they are afraid of, that uncertainty." Li believes it could take 15 years for China to make the yuan a fully convertible currency. Laurence Brahm, a China expert and author of the new book The Anti-Globalization Breakfast Club, seconds this view. Though Brahm believes that China has a long-term goal of making the yuan a top-tier global currency, he says that the major reforms needed may have to wait until new leaders come to power. "During the administration of [President] Hu Jintao, a conservative leadership, I don't think they want to do anything that is too reformist," Brahm says...

The... downfall of the dollar may be only a matter of time. But what could replace it? The British pound, the Japanese yen and the Swiss franc remain minor reserve currencies, as those countries are not major powers. Gold is still a barbaric relic whose value rises only when inflation is high. The euro is hobbled by concerns about the long-term viability of the European Monetary Union. That leaves the renminbi. ...

At the moment,... the renminbi is far from ready to achieve reserve currency status. China would first have to ease restrictions on money entering and leaving the country, make its currency fully convertible for such transactions, continue its domestic financial reforms and make its bond markets more liquid. It would take a long time for the renminbi to become a reserve currency, but it could happen. ...

....The global financial crisis gave a boost to an idea that has been floated in various quarters to encourage the use of the Chinese yuan as an international currency. Economic authorities in most countries, however, believe the idea is still a long way from being implemented.

Although China wants Shanghai to be an international financial centre by 2020, the financial community still has doubts about how the yuan could function as an international currency on the scale of the US dollar, Japanese yen or euro. Some conclude it could be an international currency; but not for many decades, while some anticipate that it could become a regional currency somewhat sooner.

Financial experts agree that China’s government faces a tough task selling the idea of the yuan as a currency that can stand beside the currencies mentioned above. China’s financial market is not only behind the financial markets in developed countries, but also behind those in some developing countries.

According to the International Monetary Fund (IMF)’s definition, a convertible currency must be convertible into any other convertible currency.

The yuan cannot be traded outside China, so it cannot serve as an international currency, said CIMB Thai Bank executive vice president Bunluasak Pussarungsri.
Secondly, yuan liquidity is inadequate. Foreign investors must be declared a Qualified Foreign Institution Investor by the Chinese authorities before putting their money into assets on the mainland.

The country’s current-account surplus is partly blamed for the insufficient supply of yuan, leaving only a small amount of the currency in the global market, Bunluasak said.
Third, China’s financial market is not deep enough, and is saddled with investment restrictions. Its financial products are not varied enough, either.

Currently, Chinese people cannot freely exchange the yuan for US dollars, while foreigners face limitations on exchanges of dollars for yuan.

“The government needs to foster growth of the market and product development,” said Suchada.
Fourth, Chinese commercial banks are not able to freely extend yuan loans, particularly to non-residents.

For example, foreign importers cannot freely borrow yuan from a Chinese bank, even though they need the currency for trade settlement.
....
July 6, 2009 HONG KONG — Banks in China and Hong Kong began wiring Chinese renminbi directly to one another on Monday to settle payments for imports and exports, as China took another step toward establishing the renminbi as a global currency — and, eventually, an international alternative to the dollar.

China has tempered its recent calls for a global reserve currency other than the dollar going into a meeting of the world’s major industrialized countries and biggest emerging economies in Italy on Thursday. He Yafei, China’s vice foreign minister, said on Sunday that the dollar would remain the world’s dominant currency for “many years to come.”

But the Chinese government is accelerating the process of making its own currency, the renminbi, more readily convertible into other currencies, which gives it the potential over the long term to be used widely for trade and as a reserve currency.

The day that the renminbi is fully convertible — more than a few years away, but perhaps less than a few decades — will most likely signal a huge shift in global economic power, and a day of reckoning of sorts not just for China but also for the United States, which will no longer be able to run up huge debt without economic consequences.

Despite the slow, cautious pace at which China is moving, few experts on Chinese monetary policy doubt that the long-term direction of policy is toward strengthening the renminbi as an alternative to industrialized countries’ currencies.

For decades, China has shielded the renminbi behind high barriers. Authorities in Beijing prevented sizable amounts of the currency from building up beyond China’s borders to allow them to control the exchange rate and tightly regulate the financial system.
By keeping the exchange rate low, China keeps its exports competitive.

But, as a result, almost all payments for China’s imports and exports, as well as international investment in China and Chinese investment abroad, are made in dollars. Smaller sums cross China’s borders as euros and yen, but seldom renminbi.
China is now starting to tear down these walls and free the renminbi — a decision driven partly by recognition of China’s rising role in the world economy and partly by disenchantment with the currencies and financial systems of the industrialized world during the current downturn.

“China definitely wants to reduce its dependence on the U.S. dollar,” said Xu Xiaonian, an economist at the China Europe International Business School. “Given the quantitative easing of the Fed and the risk of worldwide inflation, it is understandable why China would want to accelerate the convertibility of the renminbi.”

China’s leaders tend to plan far ahead, however, and full convertibility for the renminbi is likely to take years, said three people who have discussed the issue with China’s central bank policy makers. All three said that China’s recently announced goal to turn Shanghai into an international financial center by 2020 meant that China probably wants a renminbi that is fully convertible into other currencies by then.

Full convertibility is necessary for other countries’ central banks to hold renminbi in their foreign exchange reserves instead of the dollar, but not sufficient by itself. China also needs to show long-term economic and financial stability — something it has demonstrated over the past year in greater abundance than most countries.

Currency specialists and economists estimate that China still holds close to three-quarters of its $2 trillion in foreign reserves in the form of dollar-denominated assets. But these holdings have nearly stopped growing since the global financial crisis began last September, as Chinese authorities have also shifted away from the longer-maturity bonds and the securities of government-sponsored enterprises likeFannie Mae, and toward shorter-dated securities, especially Treasury bills.

Zhou Xiaochuan, the governor of the People’s Bank of China, called this spring for a greater role in the global financial system for special drawing rights, a unit of account used in dealings with theInternational Monetary Fund. But Mr. He, the vice foreign minister, said on Sunday that such discussions were an academic exercise.

Eswar S. Prasad, the former head of the I.M.F.’s China division, said that senior Chinese central bankers had told him that Mr. Zhou’s suggestions about using special drawing rights as a kind of global currency were intended to stimulate debate, and that China’s main goal is to enhance the role of its own currency.

“The Chinese authorities see full convertibility as a long-term objective, recognizing this is essential for the renminbi to become an international reserve currency,” Mr. Prasad said.
Full convertibility of the renminbi is not an unalloyed benefit for China, because it would be harder, although not impossible, for China’s central bank to continue controlling the currency’s value in terms of the dollar. A sharp rise in the renminbi could drive thousands of export factories out of business and cause large-scale layoffs, which the Communist Party fears as potentially destabilizing. A more volatile currency would also require Chinese businesses to develop more sophistication in managing risk, and most likely involve losses along the way among those that fail to do so.

In the last several months, Beijing authorities have begun moving to let central banks from Argentina to Malaysia settle payments in renminbi with China’s central bank. On Monday, the government moved gingerly toward allowing the private sector to handle more renminbi beyond mainland China’s borders.

The new program is restricted to companies in Shanghai and in the biggest cities of Guangdong Province, a center of exports next door to Hong Kong. Companies in these cities are now eligible to send or receive payments in renminbi with customers or suppliers in Hong Kong, Macao and Southeast Asia.

Chinese exporters have been eager to see the renminbi used more widely for trade — particularly after many suffered losses a year ago, when the Chinese authorities allowed the renminbi to rise 8 percent against the dollar from December 2007 until the exchange rate was frozen through market interventions in late July 2008. That rise in the renminbi hurt Chinese companies that had signed contracts to export goods for payments in dollars, only to find that those dollars did not go as far as they hoped in covering expenses incurred in renminbi.

“Expanding the renminbi usage area and making it more flexible is great news as we sell a lot to various countries overseas — this should also remove the risks associated with currency fluctuations,” said Wang Yapeng, a sales manager at Shanghai Electric International Economic and Trading Company Ltd., which exports a wide range of machine parts.

Rebel: " I suspect that one reason is that the American authorities know that they would face a very painful adjustment if the Chinese stopped buying US assets without buying a lot more US exports."

But high US net exports of assets and high US net imports of goods and services are just two sides of the same coin. Total net exports (of assets plus goods and services) are zero. If the US wants the dollar to depreciate against the yuan, in order to promote net exports of goods and services, it must curtail the net exports of assets.

This is what I was arguing several months ago in my "I hope Hillary Fails (to persuade China to keep on buying US bonds)" post.
http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/02/i-hope-hillary-fails.html

"If China stops buying US assets, it means they stop buying the dollar, which means they start selling the dollars they attract on current account surplus, which means sudden dollar depreciation."

If this only entails China ceasing to add to its reserves, not liquidating them, would the depreciation of USD really be that precipitous? I have a feeling that it would be just what the doctor ordered.

"The adjustment will be painful because the FX market disruption will overwhelm any trade benefit that the US gets as a result"

That seems like a somewhat cavalier assertion. What's the mechanism that would cause damage in excess of the clear gains in export competitiveness?

"- and would likely cause bond market yields to spike as well."

Again, is this really a problem right now?
http://www.bloomberg.com/markets/rates/index.html

Sure, there will be some dislocations, but everyone that I know would view such a move as being in the right direction, with benefits to the US that outweigh any potential costs.

“Sure, there will be some dislocations, but everyone that I know would view such a move as being in the right direction, with benefits to the US that outweigh any potential costs.”

I don’t disagree directionally; it’s a question of degree. But a spike in treasury yields would not be helpful to the mortgage market at this early stage, where the 10 year treasury yield is an important pricing reference point. Bond traders are feeling overlooked at this point, given that they haven’t had something to panic about on the downside for a long time. That’s dangerous.

The more interesting debating point is the effect on the Dollar/Yuan exchange rate. The Yuan doesn’t have to appreciate against the dollar just because China starts selling the dollar. PBOC is the monopoly supplier of dollar/Yuan exchange, and as a monopoly supplier sets the exchange rate wherever it want it. It is the only buyer of dollars against Yuan. So it has to continue buying against Yuan so long as China generates a current account surplus, which is almost entirely invoiced in dollars. It remains the monopoly price setter of the exchange rate, whatever it does with the dollars it buys. If it then sells dollars for Euros or Yen, that affects those exchange rates, and the dollar will depreciate against those currencies. But it doesn’t have to change the dollar/Yuan rate to do that. Bottom line is that the institutional arrangements for the dollar/Yuan exchange rate are separate from the choices that PBOC makes on its ultimate reserve currencies. And that will be the case so long as China chooses not to internationalize the use of the Yuan.

"If the US wants the dollar to depreciate against the yuan, in order to promote net exports of goods and services, it must curtail the net exports of assets."

The key word here is "net". What I have in mind is that net US exports would increase (actually become less negative) mainly via a decrease in US imports from China rather than an increase in US exports to China, as the dollar price of Chinese goods rises - ie shopping in Walmart gets more expensive. Of course the Americans would prefer to increase their exports to China, but they do not produce much that China is interested in buying that the Americans would sell to them, so US exports to China are unlikely to be respond much to a lower yuan/dollar exchange rate. And US long term interest rates could be expected to rise as the Chinese curtailed their purchases of US assets, which would not go down well either.

Sometimes I think that the analysis and commentary on global imbalances is too sophisticated to see the wood for the trees. Basically, in the early 1990s China (and some other countries) stopped handicapping themselves with misguided economic policies, and started to compete with the developed world. While this undoubtedly means an improved standard of living for the world as a whole, the facts that technological progress is relatively slow and that some resources are in limited supply probably means that the rise of China etc probably means that the US (and the UK; no schadenfreude here) will get poorer. The US can either cut back the required amount now or cut back more later. Unfortunately, democracies are not good at dealing with retrenchment - recall Jimmy Carter's sweater speech - so the US continues to borrow and defer their problem.

Nick, If the US wants its currency to depreciate against the yuan, it has to create an inflation rate that (adjusted for variations in the real exchange rate) is politically unacceptable in China. Of course that inflation rate might be politically unacceptable here as well. Which raises the issue of why not just target inflation (or NGDP!) in the US and forget about the exchange rate. After all, when push comes to shove it is always the macroeconomy that people really care about.

"Nick, If the US wants its currency to depreciate against the yuan, it has to create an inflation rate that (adjusted for variations in the real exchange rate) is politically unacceptable in China."

How does a higher domestic US inflation rate transmit to a Chinese political response? E.g. I can't see China being that sensitive to domestic US inflation via higher import costs. If anything, it would seem to be beneficial for Chinese exports.

I think that Scott's idea is that, since China must roughly match the pace at which the dollar money supply increases to hold the peg, the Chinese will give up if the US forces them to supply so much money that inflation begins to be a problem in China. That sounds a bit reckless to me, but Scott has his hammer, and he is going to hit problems with it.

Thanks. I did think of that. Although China seems fairly adept at issuing sterilization bills as a means to avoid the full monetary effect domestically. They've held their own so far, so I'm not sure a political sensitivity point on the size of their current account surplus is that close in sight.

I agree about China's sterilisation; it seems to have been successful. Some analysts get excited about the rapid broad money growth in China, but deposits there seem to be largely savings balances, while narrow money has not grown so fast, and such figures must be considered in the light of the generally rapid growth of the Chinese economy anyway. There I do agree with Scott - China's current account surplus is more driven by Chinese thrift than its exchange rate policy. If the Chinese were reluctant to save, sterilisation would be either inadequate or expensive.

But Rebel, can we really disentangle Chinese thrift from the exchange rate?

Suppose we agree that the Chinese will have a 60% private savings rate no matter what. Does it then follow that letting the yuan appreciate against the dollar will not reduce the Chinese CA surplus?

After all, there is a substitution effect whereby the Chinese would be likely to substitute some imports for domestic production in their consumption basket (unless you think the price elasticity of imports vs domestic production is zero).

Furthermore, there is a wealth effect. The part of their consumption basket that is imported from the US is now cheaper meaning they have more total real income. Thus they would tend to spend a bit more on everything, including imports.

Now, at the individual level the effect is tiny but there are a lot of Chinese so if it is a couple of percent of their total conumption it will make a noticable difference. And all without the overall chinese private savings rate changing.

Yes, Adam, I think we can. The exchange rate depends on how the Chinese choose to save. Saving in the form of domestic investment has no implications for the current account, capital account, or the exchange rate - it is just a switch from purchasing consumption items to investment items. If on the other hand the Chinese choose to save by lending to foreigners, then the currencies of the assets they buy will, other things equal, appreciate, and the capital account deficit will be matched by a current account surplus. It is actually not certain that the renminbi would appreciate if it became convertible, because Chinese citizens are not presently free to buy and sell foreign assets and thereby make their own adjustment to the amount of external saving being done on their collective behalf by the government. However, the high level of domestic investment does suggest that internal savings opportunities are being heavily exploited already.

I like your analysis, but disagree, if those two things are jointly possible.

When PBOC takes in foreign exchange from exports, it effectively short circuits what otherwise would be a more liquid private sector flow of foreign exchange. The flow of dollars is more constricted. This includes dollar access for importers. Yes, importers can buy foreign exchange from PBOC. But would you deny that there is an effect on the “liquidity” of the import market, and the corresponding access of Chinese consumers to an import flow backed by a more diverse source of finance? So why wouldn’t such a constriction of import commerce and financing have a direct bearing on Chinese thrift in the sense of import supply constriction? And if so, isn’t the FX institutional arrangement a contributor to such thrift?

Nick said: "Too much Fed: for once, we agree ;). I think the world money supply would expand, and all/both currencies would depreciate against real goods,"

Yea! We agree!

Nick also said: "which is what we want right now, to offset deflationary forces."

Sadly, I disagree. With an oversupplied labor market so that wage income does not rise, that scenario will only lead to real earnings growth becoming more negative, making it harder to service the debt.

IMO, price inflation should come from real earnings growth and if necessary, more jobs. IMO, price inflation should NOT come from more debt denominated in currency and/or currency devaluations.

Rebel, I agree with everything you said but I don't believe it addresses my arguement. Everything you said refers to what the Chinese do with the 60% of income that is saved. I'm talking about what happens to the 40% of income that is consumed.

Scott: good to see you back here. I've been reading your related post, and discussion in comments with "original anon".

I have made several attempts to give an intelligent response to your comment on inflation. But every time I try, I realise my head is just not straight on it yet. Hoping I will eventually figure out what I think, or ought to think.

The other thing I would really like to get my head straight on is this: "And if so, isn’t the FX institutional arrangement a contributor to such thrift?" from original anon.

The same point came up on another post a few months back. And I thought I understood it then, even if not clearly. I think it's important. China's forex intervention is also a form of public saving. So it depreciates the real exchange rate, even in the long run, just like running a budget surplus.

“Original anon, That policy mix might make some sense. But that’s not really what Krugman is doing. He is not calling on some countries to ease by the same amount as others tighten. He is calling for China to tighten, regardless of what others do. He has indicated that he expects no further moves toward monetary ease from the major central banks. So a Chinese revaluation would be “negative E” in net terms.”

Given that the US dollar is a floating rate currency, currency easing as I’ve defined it is imposed by the market. That’s what’s been happening recently through dollar depreciation. I’m not sure Krugman is so opposed to US dollar depreciation, so long as its gradual rather than cliff diving. Maybe I’ve missed it, but I’d be interested if you’ve picked up on something different. In fact, dollar depreciation is consistent with his concern that global imbalances be corrected.

What he is suggesting with respect to the Yuan is in effect a more orderly approach to the correction of global imbalances. In contrast to the free float market priced dollar, the Yuan is a fixed rate currency whose price level is determined by PBOC rather than by the market. To the degree that further dollar depreciation is possible, then Krugman’s call for Yuan tightening makes all the more sense, as per my example above. It basically redistributes global easing marginally in favour of the US and eases up on the tightening that would otherwise by imposed on Europe by further dollar weakness – again as per my example. In other words, China’s tightening against the dollar serves to diversify global currency effects from what they otherwise would be. The existing Yuan fix has the effect of concentrating currency effects outside of China, which is not good for the correction of global imbalances.

So I think that Krugman very much has the risk of further dollar depreciation in back of mind when he suggests a strategy of Yuan currency tightening (pegging higher against the dollar) by PBOC.

original anon, I suppose you must be right that, although the Chinese authorities are supposed to provide unlimited liquidity at the peg exchange rate, in practice, the questions that they might ask can deter exchange somewhat. But it less clear whether that friction is hindering Chinese purchases of overseas consumption items or assets. I think that there are better explanations for Chinese thrift than exchange control - eg lack of social security.

Adam, I am not sure I am following you, but, since I usually learn from discussion with you, let me try to say something relevant about consumption. If the Chinese authorities made the renminbi convertible and stopped intervening, and the Chinese private sector did not simply replace the official overseas asset purchases, then the renminbi would appreciate and both Chinese and overseas consumers would substitute foreign goods and services for Chinese ones. While the overall decrease in demand for Chinese goods and services might be expected to lower their renminbi prices and generate increased overall consumption in China, if Chinese propensity to save has not reduced, the reduction in interest rates as the Chinese authorities stopped selling sterlisation bonds could be expected to stimulate domestic investment, and (probably after a painful adjustment period) shift domestic production into investment goods.

If the idea that China should invest even more of its GDP seems crazy, I agree. That is why I argue that, if one accepts that Chinese saving is either their own business or reasonable, global imbalances are actually not a problem at all. The real problem is America's (above all, but a similar argument applies to Britain) refusal to invest more. As I have argued many times on Brad Setser's blog and in detail in a couple of posts on my blog, official capital inflows from China should have been an advantage to America, but they were unable to organise themselves to exploit it.

Really interesting discussion. Here are my thoughts: (1) Opium wars? The CIA could probably get quite a few Yuan that way. (2) Couldn't the US just stop paying interest on bonds held by the Chinese? They could put them on some kind of list, they seem to like security lists that prevent the export of goods to certain places. (3) Pull a Kim, just start printing Yuan in the US and dump them on the Chinese economy, causing such enormous inflation the Chinese are forced to raise interest rates or something...

However, any of these options would likely cause retaliation. Possibly war. Pick your poison.

Rebel, in terms of real investment in real productive capital China should in fact be investing even more. Part of the problem in the bubble years was that, because they were trying to keep the value of USD up, a large part of Chinese national savings (the total, public plus private) ended up in US treasuries (they clearly had to buy USD denominated paper to raise the value of USD). Thus, a large proportion of Chinese national savings was indirectly funding investment in the US! And of course the disaster was it all went into unnecessary fixed residential leaving us with an overhang of essentially useless fixed residential capital.

At the same time, a major reason that Chinese real wages are so very much lower than in the US is that their capital to labour ratio is so very much lower than the US's. They should have been funding capital investment in China not housing in the US! And they still need more captial, it's a truly giant labour force.

Now, to be clear, I'm not saying that they should save even more of their income. But they should invest more at home instead of buying US treasuries and USD which they are only doing to maintain the currency peg.

My argument above was simply that letting the renminbi appreciate vs USD would change consumption baskets to help close the US CA deficit/Chinese CA surplus. At the same time it would stop diverting Chinese savings into US treasuries and put it into real domestic investment. Finally, lower Chinese interest rates would also help as it would tend to reduce the savings rate and increase domestic real investment.

Just to clarify, if I recall the national accounting identity gives S - I = NX.

If that's correct and noticing that net exports are large for China then it follows that although savings are very high in China real investment is lower (perhaps still high, but much lower than savings). But for a country with a capital labour ratio so much less than the rest of the world it should be the opposite, they should be importing capital not exporting it!

Nick, I think one problem here is that the debate involves all sorts of concepts that are tough to integrate:

1. Short run vs. long run
2. Real exchange rates vs. nominal exchange rates
3. Open vs. closed capital markets.
4. The possibility that hot money evades capital controls
5. The nominal exchange rate as an exogenous policy instrument, or an endogenous price
6. The real exchange rate as a policy instrument or endogenous price
7. Government savings as an exogenous decision or an endogenous response to exchange rate policy

And I could go on. For most countries I think it makes sense to see the capital account as determining the current account balance. And for most countries I think monetary policy affects nominal exchange rates in both the short and long run, but real exchange rates only in the short run.

China isn't most countries. The question is to what extent do China's special characteristics change the standard model. Especially in the long run. To answer that I'd need to know things like how the Chinese government thinks about its reserve accumulation. Is this an intentional policy (with the exchange rate endogenous), or is this just the by-product of an exchange rate policy? Or is it some of each?

The only thing I have a fairly high degree of confidence in saying is that it is a waste of time for the US to worry about the Chinese saving too much, when we save far too little and need to get our act together.

Scott; Yes, your list of 7 does help explain why this debate is so difficult. But I worry about those with a positive net financial asset position continuing to save too much, as well as those with a negative net financial position continuing to save too little. My gut feel is that financial markets can only handle so much.

Well, lets see;
The Chinese government thinks they have their domestic economy and banking system under control.
But they have allowed a generation of corrupt and greedy princelings (see above) to thrive and prosper.
These guys would like to have lots of their money outside mainland China;
even nowadays, they would like mucho dollariiii.
I think you open a window, you might be surprised who shows up.

... you can only keep some people under control if they choose to accept it ...

How about-
Since China is buying up Africa and its mineral wealth, how about Langley asking the African dictators just to take their moolah in yuan. The US has never let morals and ethics get in the way of business and the American way.

The problem with the US buying Yuan is that we don't have anything to buy it with (nearly 12 Trillion in the hole and rising) as we are a debtor nation. This also has to do with the falling rate of the dollar in that people around the world are seeing less value in the dollar because of our debt level. (Would you lend money to someone who makes 50K a year and has a debt level of 200K? at less than 4% interest?) The Yuan is not a free float currency like most of the worlds "money" is, which means that folks in South Africa would rather have dollars than Yuan. (Actually, they would rather have Gold, but that's another topic) China seems to have a long-term plan when it comes to stepping onto the world stage, which conflicts with the aforementioned Gang of Princelings who have a good thing and don't want to mess it up. As a result, China is quietly diversifying it's holdings, buying commodities with it's dollars while they still have value. The end result will be China having less dollars, more goods and a good platform to ease into the dominance of the Yuan when they decide to do so. The rest of the world, the US included, is just along for the ride unless the whole thing blows up in revolution as the standard of living in the US declines.

Nick,
Thoroughly enjoyed all the discussion your question generated. I know that this comment is a bit late, but I don't recall seeing any one mention that the U.S. could credibly commit to devalue against the yuan. The task is to make the raise price of traded goods relative to non-traded goods (i.e. a real devaluation). To do this the US would simply apply an export subsidy to US exports to China and a tariff on Chinese imports. (This is a symmetry result based on work by Abba Lerner in the 1930s).

There would be some enforcement problems, how would you prevent goods that received an export subsidy from being diverted from china to say, ... Canada? And the tariff may contravene WTO rules. Still It beats transferring large sums of currency in containers.